Banks had a tough year in 2019. Weak economic results, global political tensions, including US-China trade tensions and Brexit-related uncertainty did not help.
In 2020, these issues remain unresolved. The IMF is forecasting a slight uptick in overall global growth. On the other hand, monetary loosening in both Europe and the US is likely to increase pressure on bank margins. And at the same time it will slow revenue growth.
Banking in the new decade: EY
A must-read report entitled Banking in the new decade from EY argues that banks need to focus on freeing up capital.
Specifically, banks must focus on sustaining or boosting profitability if they are to fund investment in digital transformation.
Furthermore, the report notes only half of the world’s largest 50 banks will achieve double-digit return on equity in 2020.
These utility-like ROEs are unlikely to satisfy investors for long, unless they are also accompanied by low volatility.
As a result, banks must improve customer experience to sustain revenues. Meantime, they must radically reduce costs. This is driving significant digital transformation initiatives.
Many large banks have announced multi-billion dollar technology investments. But it is not always clear how banks expect to maximise the return on these investments.
What is certain is that the banking sector remains committed to investing in technology to transform customer experience,
The challenge will be how to free up capital to fund these investments, as different factors impact profitability.
Increased competition from innovative new competitors is also squeezing bank margins notes EY.
These challengers are not only attracting customers, but investors too. Fintechs and Big techs benefit from an absence of legacy systems. As a result they can invest in the latest technology and customer experiences, rather than just keep existing systems ticking over. And despite many challengers being in an extended cash burn phase, most report valuations significantly above book value. In contrast, bank valuations are typically below book value.
For example, the value of the entire European-listed banking sector is only slightly higher than that of Apple.
Europe is over-banked: EY
Concerns about profitability are driving increased discussions of consolidation across the sector. There is one bank for every 82,000 individuals in the EU. Most are inefficient with numerous cost transformation programs of the past decade failing to lower efficiency ratios below 60%.
The average cost-to-income ratio of European banks is a far too high 62.3%.
Average ROEs remain well below the cost of equity, at less than 7%. Recent improvements in profitability have been principally driven by lower impairments rather than income growth.
Cross-border activity to remain low
But as the report neatly summarises, cross-border M&A is likely to remain low. There are for example issues over lack of progress on Banking Union. Moreover, any bank looking to grow (or shrink) inorganically still needs to think carefully about how they can do so in a value-accretive way.
How do you grow through acquisition without destroying value? How can you exit businesses without retaining the costs of underlying systems?
So in 2020 the focus of banks’ efforts to improve profitability will be on cost reduction. In fact, without revenue growth, European banks will need to cut almost one fourth of their cost base to achieve the industry’s typical ROE target of 12%.
Achieving this will require firms to look beyond traditional cost-cutting approaches. It needs, says EY, radical transformation.
Scaling back and re-configuring branch networks is also required, alongside increased automation. And it needs simplification of products, services, and underlying processes and use of partnerships to build scale.
The difficulty for banks will be deciding how to free up capital to invest in this transformational agenda.
US: war for talent amid technology transformation
In the US, the banking sector continues to deliver double-digit returns. This puts US banks in a comparative position of strength. A bounce back in financial markets drove record performances for a number of institutions.
As RBI noted in December, 2019 was an outstanding year for shareholders in the largest US banks.
Citigroup led the way among major US lenders with its share price ahead by over 40%.
But the world’s largest two banks by market cap, JPMorgan Chase and Bank of America also enjoyed a stellar 2019.
Both Chase and Bank of America share prices rose by more than 33% in 2019.
Can this be maintained? Market fundamentals remain positive.
While there has been a decline in business confidence, consumer confidence — the core driver of the US economy — remains robust.
This may drive differentiated performance across the commercial and consumer banking segment. But even in consumer banking, risks remain. Estimates suggest that about one-third of US workers are freelancers or part of the gig economy.
With such a large part of the workforce in precarious work, greater unemployment means customers struggle to service their debt. The end result: a rise in bank’s non-performing loans.
This means US banks too will seek efficiency gains to sustain profitability and support a digital transformation agenda.
Banking in the new decade: 200,000 US jobs at risk?
US banks have the capacity to continue investing in technology and digital transformation, to improve customer experience and cut costs. This agenda will continue to drive branch closures, reflecting customers’ growing preference for digital banking channels, and M&A activity.
The US market is even more over-banked than Europe. And not all banks will be able to make the investment in the digital agenda that customers are demanding.
As RBI noted in September, US branch closures are accelerating, albeit at a pedestrian rate compared to large parts of Europe.
By international comparisons, the US remains over-branched and there remains scope for further large scale branch closures.
EY suggests that investment in technology could see up to 200,000 job cuts in the industry over the next decade.
But as RBI reported last September, meantime employment numbers continue to hold up at the largest banks in the US.
But while banks may reduce headcount in certain areas, the deployment of new technologies requires bank employees to develop new skills.
Banks universally acknowledge they need to hire individuals with a greater understanding of new technologies.
Banks remain a popular employer for business graduates. But no traditional bank features in the top 30 most attractive firms for engineers.
Competing for leading talent with global technology companies as well as a handful of global banks is likely to leave most US banks facing a chronic staff shortage to support their digitisation initiatives. Staff recruitment and retention to support digital transformation is set to become a new battleground for the sector.
Asia-Pacific competition drives investment in digital transformation
Banks in the Asia-Pacific region will not escape margin pressure.
In 2019, interest rate cuts were cut at several central banks, including those in India, Australia and Hong Kong.
Many Asian economies are manufacturing exporters. A slowdown and weakened demand in Europe or the US will flow through to these markets. The result will be a rise in nonperforming loans and associated impairment charges.
However, banks in most Asia-Pacific markets are in a strong position to manage these risks. They are generally well capitalised
While average ROEs have consistently fallen since the global financial crisis, they remain in double digits.
Efficiency ratios are significantly better than those in the US or Europe.
Of greater concern is the risk that new competitors pose to incumbents. Asia-Pacific is home to successful BigTech banking competitors, a thriving FinTech scene and leading digibanks. Open banking agendas across the region, whether regulatory driven as in Australia, or more organic as in China, will encourage competition.
Liberalisation in China is also likely to change the competitive dynamic in the region.
And so banks will need to continue investing in building digital banking capabilities to further drive efficiency and productivity.
Doing this successfully will help banks reach more customers, especially unbanked and underbanked individuals and micro, small- and medium sized enterprises.
EY estimates that this could generate an additional $800bn in revenues across Asia-Pacific.
Freeing up capital when profits are weak
In 2020, banks will face the twin challenges of cutting
and investing in transformation. EY says four areas of focus can help chief operating officers do both.
- Focus on marginal costs;
- Reassess non-strategic activities;
- Stop the leaks
EY sees leakages across the product set, but especially in areas such as current accounts, credit cards and consumer credit or with bundled products, where fees are not consistently charged. These leaks can be small at an individual level, but add up to a significant loss. EY has seen banks lift their revenues by double-digits just by applying rules correctly.
- Prioritise legacy system challenges ahead of new innovation
These challenges include an inability to run in real-time. This stymies the development of the new services and experiences customers demand. Nearly 50% of banks do not upgrade old IT systems as soon as they should according to the FCA. Only when legacy issues are addressed can banks adopt a more agile approach and lean thinking for investment allocations. And have a DevOps approach to implementation.
Banking in the new decade: fintechs raise bar
Fintechs and Big techs have raised the bar for customer service. But high-performing incumbents are maximising two competitive advantages. They have deep customer insights and the ability to use their size to lower costs. Building on consumers’ higher levels of trust in their primary financial services provider, delivering easier, more intuitive experiences and supporting customers to achieve wider goals, can help banks leverage these advantages to grow revenue.